As part of Morningstar's 5 Days to Better Investing, we're checking in today with our director of ETF, closed-end fund, and alternatives research Scott Burns to learn a little bit more about the fundamentals of good ETF investing.

Thanks for joining me, Scott.

Scott Burns: Jason, thanks for having me.

Stipp: So you mentioned to me recently that investors will come to you and they'll say, "Scott, I need to buy an ETF. What kind of ETF should I buy?" And you tell me this is absolutely the wrong question to start with. What's the problem there?

Burns: So you know the problem, they say, "I am looking for an ETF," and I always want to say to them, "Shouldn't you be looking for an idea first and then we'll go look for the ETF."

I think maybe some of that is semantics, but I do think unfortunately that a lot of people are just looking for that. "I am looking for stock; I am looking for an ETF." But that's not the way institutional investors invest, that's not the way money managers whether they are doing asset allocation with ETFs or even buying individual stocks, do things.

They think about an investment idea. They look for an opportunity, and then they check to see what kind of products are out there and see if there's mismatches in pricing, and what's the right product to match that investment idea. So, I guess, it's a little bit of the cart before the horse that's out there. So I always tell people, the first step to picking a good ETF is picking a good idea.

Stipp: Let's say you have the idea, whatever it might be. There are some reasons that you might look at ETFs and then there are some reasons that you might look at other types of investments, depending on what your needs are and what your idea might happen to be. What are some of those times when you would want to check out ETFs and see what they have to offer? And what are some times when ETFs might not get where you want to go?

Burns: You know, I mean ETFs definitely fit in role in the portfolio. I own ETFs and stocks and active mutual funds. I think if you're looking for ETFs on a strategic standpoint, you've really adopted a passive investing philosophy if you're going to use those at your core.

If you looking for ETFs to be more sophisticated tools, that is to pair them with maybe some other active mutual funds or some other individual holdings that are out there. ETFs are sliced and diced, a lot of people critic that, but that's actually one of the nice things is that you can get some ... pinpoint precision, whether it's portfolio completion or risk management or liquidity.

Then you have ETFs on the tactical side, where you're making tactical active investing, even active trading-type bets. If you're going to select an ETF there, I mean where I think it makes the most sense is where you think you're going to have broad price divergence across a category and not so much just one-off names that are off.

One of the other reasons I think you pick ETFs over, say, individual stocks is your investment thesis is only going to be at a very macro level and not be able to get down into the piece parts.

At the same time, there are a lot of ETFs that have a lot of significant weightings in single holdings. If you think of some of the broad energy ETFs that are 45% Exxon and Chevron. If that's your thesis, you may be better off just buying Exxon and Chevron, and saving yourself the management fee, basically, on the fund.

So it's always important to know what you own, and there are those trade-offs. If you want to buy an ETF and you expect it to beat the index, that's where you're going to want active management.

So those are definitely I would say the laundry list.

Stipp: So for strategic investors, historically, there have been concerns that you might rack up transaction costs in buying ETF, but some of those aren't really as big of an issue anymore issue on certain platforms. So it could be that you don't have to worry as much about those transaction costs with ETFs for the long-term investor.

Burns: There are plenty of platforms out there--Fidelity, TD Ameritrade, Schwab, Vanguard, Scottrade to name a few--that have ETF offerings. It's not all ETFs, it's usually a fairly select list. Sometimes it's their own internal product. But you can trade those without transaction fees, which is a great idea for a smaller investor who is looking to accumulate or dollar-cost average money across a timeline.

If you are on a platform where you're looking at product that doesn't fall into one of those [no-transaction-cost buckets], then you do have to take the transaction cost into consideration, and you do not want to drip $200 of money a month into a fund that's going to charge you $10 for a trade-in and $10 for a trade-out--that's very counter-productive. But I think the broker-dealer world and the asset management world have solved a lot of this tension, so people do have choices.

Stipp: Okay. So, let's say, for example, that I have decided to have an investment thesis in energy. I want to target energy somehow, and I look at the ETF landscape, and I see several ETFs that are in this area. How do I start to sift through those and find exactly what I want? What things should I be looking at there?

Burns: Well, energy is a great example because you have a lot of different ways to access energy in the ETF space. You can buy energy futures. You can buy an oil-futures-holding ETF. You can access equities as well that are in the oil and gas exploration space.

So, you want to think about, again, going back to your idea, what is your real idea about where you think the investment is going. Do you want to buy energy stocks because you think oil is going to go up, and how confident are you in that? Even inside of energy, they are very cap-weighted, dominated by Exxon and Chevron-type funds. There are other ones that are further down the food chain, in the "wildcatting" or in the MLP space. So, there are a lots of different ways. And that again kind of comes backs to that thesis. What is it that you're actually trying to capture?

Going large cap gives you're more ballast and a little less leverage, operating leverage that is to rising commodity prices, but it also gives you a little more stability. But if you're very confident that you think oil is going to rise, then you're going to want to go down into some more of the service providers and companies that have a lot of operating leverage to those things.

So, again, whether it's health care or energy, you have to think about what is it that you're trying to access and then get inside that ETF, look under the hood, understand how the index is composed, what it actually holds, and know what you want ultimately.

Stipp: So, there are a lot of ETFs that will target similar indexes, so how important is it and how much divergence do you see, in the fees of these funds. Do you still see that there are some S&P 500 funds; for example, that are much cheaper than other S&P 500 ETFs.

Burns: It's definitely case-by-case basis, and you can't say, "well, this provider is always the lowest cost provider." You see areas where there are trade-offs. So, the ability to go through a screener, like Morningstar.com has, and line up those factors, once you've settled on a category and an investment idea, is something that's definitely worth your time.

The other thing with ETFs is, there is the holding cost--that expense ratio--and if you're a long-term investor, that's usually the most dominant factor towards your total cost. But there is also a liquidity factor as well, and so understanding how liquidity and that expense ratio trade off is very important. We've produced statistics on Morningstar.com at the bottom of all our quote pages that lay out market impact and category ranking, and estimated holding costs and category ranking for investors to look at.

Stipp: One thing, obviously, that you want an ETF to do is follow its index well. So most of these funds are index funds. How can you make sure that the ETF is performing the way you had anticipated it to perform, and given that they are traded on exchanges and do have prices, there can be divergences, premiums or discounts, compared to that underlying portfolio. Is that a problem, and how do you gauge whether those are higher than they should be?

Burns: The U.S. ETF market is actually incredibly efficient. So, when we looked at it 10 years ago, I think you would worry about things like that, about premiums and discounts and wide spreads.

But by and large, where ... the majority of ETF assets are, these are some of the most liquid securities on the planet. These are some of the best tracking securities on the planet. In fact, when we've done studies comparing the tracking error of ETFs to even open-end index funds, the ETFs have generally outperformed even on tracking.

There is some cause for concern. I think once you get into ... there is 1,300 ETFs out there ... when you start looking at the 500 smallest, I think you have to start worrying about that a little bit, because they are niche, because people aren't really watching them as much.

So when you wander out of the mainstream and into some of the smaller areas, you do want to keep an eye on premiums and discounts. Again Morningstar.com as well as other sources can provide that information. And You definitely want to keep an eye on spreads. So some of the best practices around that: You can avoid premiums and discounts and wide spreads altogether if you just use limit orders when you're making a purchase in some of these less-than-liquid ETFs. So using a limit order at the NAV. Actually one of the ... newer developments on Morningstar.com is that we're now showing the [indicative] NAV price right below the actual market price, and so it makes a lot easier for investors. It took me years to figure out, why is it so hard to find the I-NAV to this [ETF]? Why do I always have to tell people, type in the "^" symbol and then the ticker, and maybe you'll find it. So, I am glad we've taken the step to now show both the I-NAV and the market price on our quote pages.

Stipp: So I want to talk a little bit about star ratings. This is something obviously that our mutual fund investors are very familiar with. We also have star ratings on ETFs. They are compared to other funds, ETFs and mutual funds, in their category. I think ... some investors might say, well, these are index funds. They are tracking the broad market. They are going to end up with 3 stars. Is that the case and how do you use star ratings as you are going through and looking at these ETFs?

Burns: For cap-weighted ETFs that is academically what you should expect. We should expect ETFs, especially if they are following benchmark-type indexes ... from different providers, to be 3 stars, but actually we often find that they are 4 stars. A little less rarely do we find that they are 2 stars. And really what I like to tell people is that when you find ETFs that are 4 stars or 2 stars, it actually tells you more about the active management in that space, perhaps than the index.

But when you get a 4-star S&P 500 ETF, that's telling you that buying the average, as people say, is actually a well-above-average proposition for you. A 4-star fund outperforms 85% of its peers in the category, and that includes active and passive and everything else out there. So when you have a 4-star ETF, the odds aren't 50-50 that the index is the better bet, it's actually 85-15, historically, looking back.

We do see 2-star ETFs, though, actually. We do see areas where there is a liquidity problem, that is, the underlying isn't as liquid. So what we think from that, 2-star ETFs that we see in high-yield bonds, 2-star ETFs in small cap, some of the small-cap areas, that tells us that active managers are adding a lot of alpha, but maybe not necessarily from security selection, but actually just from their ability to transact away from the index and maximize on some of the liquidity inefficiencies in those markets. And frankly, that's part of an investor return. So you won't catch me saying, "That's crying foul." If you hire an active manager, the least they can do is trade for your portfolio. So, we do see that.

The one area where we see 5-star ETFs that is shocking, I think, is in emerging markets. The broad-based emerging-market ETFs, the two big ones, EEM and VWO, and there are other emerging-market cousins out there that all perform fairly similarly, are all 5 stars. So, I think the old adage that when you are in emerging markets you really need active management, and that's where you get a big edge, it just isn't proving out true right now. It just shows that the index funds have been the better bet.

Stipp: At least in the emerging markets, which is something that goes against what the conventional wisdom had been about that space, so that's some interesting texture around the star rating there.

Last thing I wanted to ask you is about the fact that these ETFs are traded on an exchange, and this is the flexibility that some investors want to have and one of the reasons why they will look to ETFs.

You mentioned liquidity as something to keep an eye on in some cases. What else should investors have on their radar if they're going to really be taking advantage of this exchange-traded attribute of ETFs?

Burns: We talked a little bit about liquidity and limit orders, but frankly I think for a lot of investors if you are moving from say traditional mutual funds into ETFs, you have to take the time to understand what that "exchange-traded" part means. You have to understand what limit orders are and bid-ask spreads and the ability to make the trade. When I was at an event after talking about all these things that you have to do with ETFs that are different from mutual funds, somebody raised his hand, this gentlemen, and said, "I thought these were supposed to make my life easier."

And I said, actually no, that is not one of the promises of ETFs. It's low cost, transparency, tax efficiency, liquidity. But easier is actually not one of them. But in exchange for all those things, there are actually some more complicated steps.

So, making sure that you understand how to do transactions is utterly important, because to have a good investment idea, use a good tool like an ETF, and then make a bad execution is something that will destroy your returns more than even your investment bet.

And I think for those that are coming from traditionally using stocks and are comfortable with trading, but are comfortable with trading stocks, the advice I have to give people on that is that, you actually have to truncate your expectations a lot. When you diversify across a theme, things like growth expectations, things like stop-loss orders, the numbers become so much tighter, that diversification really trims things in so. So when we had the flash crash, we had people who had 20% stop-loss orders on Vanguard Total World Market. That might be acceptable for Green Mountain Coffee or some other kind of cult stock out there that's got a lot of volatility. But for the Total World Stock Market it's not going to be very helpful, and in fact in terms of the flash crash, it was kind of harmful. So, you have to understand the scale of things really starts to change in how you set your expectations, your investment horizons, etc.

Stipp: Well some great insights. Scott Burns, director of ETF, closed-end fund, and alternatives research, thanks for being here today.